(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 188

CHAPTER • Uncertainty and Consumer Behavior 163 Probability F IGURE 5.1 OUTCOME PROBABILITIES FOR TWO JOBS 0.2 Job 0.1 Job $1000 $1500 $2000 The distribution of payoffs associated with Job has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job Both distributions are flat because all outcomes are equally likely Income graphically (If there had been only two equally probable outcomes, then the figure would be drawn as two vertical lines, each with a height of 0.5.) You can see from Figure 5.1 that the first job is riskier than the second The “spread” of possible payoffs for the first job is much greater than the spread for the second As a result, the standard deviation of the payoffs associated with the first job is greater than that associated with the second In this particular example, all payoffs are equally likely Thus the curves describing the probabilities for each job are flat In many cases, however, some payoffs are more likely than others Figure 5.2 shows a situation in which the most extreme payoffs are the least likely Again, the salary from Job has a greater standard deviation From this point on, we will use the standard deviation of payoffs to measure the degree of risk Decision Making Suppose you are choosing between the two sales jobs described in our original example Which job would you take? If you dislike risk, you will take the second job: It offers the same expected income as the first but with less risk But suppose we add $100 to each of the payoffs in the first job, so that the expected payoff increases from $1500 to $1600 Table 5.4 gives the new earnings and the squared deviations Probability 0.3 F IGURE 5.2 0.2 UNEQUAL PROBABILITY OUTCOMES Job 0.1 Job $1000 $1500 $2000 Income The distribution of payoffs associated with Job has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job Both distributions are peaked because the extreme payoffs are less likely than those near the middle of the distribution